Tony Featherstone Columnist

Tony is a former managing editor of BRW, Shares, Personal Investor, Asset and CFO magazines. He writes a weekly column for BRW and The Australian Financial Review, specialising in small listed companies,IPOs, entrepreneurship and innovation.

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Opportunities about in small and mid-caps, but be selective

Published 28 March 2013 07:10, Updated 28 March 2013 13:15

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Small and mid cap stocks are supposed to lead sharemarket rallies as risk appetite returns and investors hunt for the next big thing. Not this time. Small stocks have badly underperformed larger ones and are collectively in the red over the past year, despite an emerging bull market.

The S&P/ASX Small Ordinaries Accumulation index, a measure of stocks ranked 101 to 300 by market capitalisation, has shed 4.4 per cent over 12 months. The S&P/ASX 100 Accumulation index is up 23 per cent (assuming dividend reinvestment) as investors clamour for blue-chip stocks with delicious dividends.

Over three years, the average annual return for the S&P/ASX 100 has been almost 6 per cent – solid rather than spectacular, but still miles ahead of a Small Ords index, which has gone nowhere. Reliable blue-chip income stocks have delivered better returns, as the chart shows, with less risk.

That underperformance could quickly reverse if the bull market finds its second wind in the next year and professional investors add more risk to portfolios by increasing asset allocations to small cap Australian shares. The Small Ords has a habit of producing a big return every five years or so, and a 27 per cent performance gap between large-cap and small-cap stocks over 12 months is rare.

Contrarians will lick their lips at the prospect of this huge gap narrowing later this year as more funds eventually flow to undervalued small companies.

Performance fears

A key question is whether the underperformance of small-cap stocks relative to large ones is because of structural rather than cyclical forces. Persistently low interest rates will continue to fuel demand for blue-chip income stocks with yields well above bank term deposit rates.

And the rise and rise of self-managed superannuation funds is creating an army of investors who are willing to pay a premium for shares in companies that can deliver a stream of reliable, fully franked dividends. It is no surprise that Telstra and Commonwealth Bank of Australia are poster stocks in a yield-hungry market.

These trends are far less favourable for small and mid-cap stocks, which typically pay lower dividends – or none – because they need to retain and reinvest more earnings to fund growth. Also, the higher risk profile of small and mid-cap stocks means they hold less appeal for retirees than blue chips.

Small and mid-cap stocks are expected to lead market rallies because they have greater leverage to an improving economy, are more nimble, and benefit from rising investor risk appetite. That has been the case in the United States, with the Russell 2000 index – a widely watched barometer of small cap stocks – up 14 per cent over 12 months, and outperforming the Dow Jones Industrial Average over the first few months of the year.

By contrast, Australian small-cap stocks are badly underperforming as the struggling resources sector weighs on the Small Ords index. Mining and energy stocks, badly out of favour in the past year, make up almost a quarter of the index.

Industrials have done much better: the Small Industrials index is up about 10 per cent over the last year.

Believers in small-cap stocks will dispute claims of a stronger, more permanent bias towards large income stocks as the population ages and retirees need greater income certainty. They will argue investors buy shares, not indices, and that index comparisons are the preserve of professionals.

Professional investors, in turn, will argue that what matters is relative performance – how their return compares with the Small Ords. On this count, Australian small-cap managers have an excellent record in outperforming their index. Their strong portfolio returns suggest investors should focus more on small caps because that market is less efficient than S&P/ASX 100 stocks.

Eight to watch

BRW’s analysis of the small and mid cap stock outlook for 2013-14 suggests three things. First, investors should not assume small caps will outperform large caps as risk appetite builds. This looks a very different bull market from previous cycles, and much depends on resources stocks.

Second, investors must exercise care with speculative stocks, such as junior explorers. Small resources stocks look much cheaper than a year ago, but it seems too early to dive into junior mining and energy stocks, given the absence of an obvious re-rating catalyst.

Third, investors must be more selective than ever with small and mid-cap stocks in this market. Yes, a rising market will lift more stocks. But this is a stock picker’s market, at least in small and mid-caps. Gains will be hard won in small caps over 12 months.

This thinking informs the small and mid-cap stocks chosen here. Resources stocks are notably absent, and only one mining service stock features. The goal was to identify higher-quality small-cap stocks still offering good value. So here are eight to watch in 2013-14.

1. Breville Group

The kitchen appliances maker soared from $2 in early 2010 to $7.34 this year. Then it shed almost $2 in one trading session in February after a disappointing interim result and the potential revision of a key contract that could crunch earnings. Breville looks to be entering a period of slower earnings growth than the market is used to, but it is still one of the highest-quality small-caps stocks – and offers better value at current prices. Watch for it to retrace recent share-price losses over the next 18 months.

2. OrotonGroup

The upmarket retailer is ideally placed to capitalise on a rebound in discretionary spending. The real story is Oroton’s internet strategy, which is well ahead of most small retailers and department stores. At $7.59, it is down on peak prices above $9 in early 2011, when the market underestimated challenges in retail. Oroton’s loss of the exclusive license for the Ralph Lauren brand in Australia and New Zealand, from June 2013 has also weighed on sentiment and earnings forecasts.

Expect OrotonGroup to test $8.50, then $9, as retail sales growth strengthens in the next 18 months and it expands its brand faster in Asia.

3. Nick Scali

Rising house prices and signs of improving consumer confidence are good news for furniture retailers. Key stocks Nick Scali and Fantastic Furniture have excellent records and well-regarded management.

Judging by its latest profit report, Nick Scali is growing its market share and management believes 2012-13 net profit could be up 20 per cent on the previous year.

The stock soared from $1.70 to $2.10 on the result, but still looks reasonable value for long-term investors. Watch for new highs in the next 12 months as the home building cycle improves.

4. Data#3

Demand for information technology service providers has been sluggish as budget-pressured federal and state governments and corporations have been forced to cut back or defer their IT projects.

Consequently, software service stocks mostly underperformed the market over 12 months as their profits fell. Technology One and UXC have been exceptions, but look fully valued after stellar gains.

While Data#3 has consistently delivered a higher return on equity than its information technology service provider peers, its share price has limped this year. This IT service provider will be a tech stock to watch as the market starts to anticipate a recovery in technology investment either this year or into next year.

5. Chandler Macleod

Recruitment companies lost favour in recent years as investors fretted about a weakening labour market and lower demand for headhunters. A slightly higher unemployment rate in 2013-14 is likely as the mining investment boom tapers, but not enough to derail a stronger recovery in recruitment stocks.

Skilled Group, a recent standout, looks fully valued at current prices. A smaller recruiter, Chandler Macleod, has rallied from 30¢ in late 2011 to 59¢ as the market has warmed to its strategy and management efforts to grow the business in tough market conditions. It looks ideally placed to capitalise on an improving recruitment market beyond 2014.

6. Mastermyne Group

Mining service stocks were battered last year as commodity prices fell, many resources projects were cancelled or deferred, and expectations grew that the mining investment boom was coming to an end.

Wiser heads realised the boom was slowing from a high base, and that higher-quality mining service companies still had much to offer. Coal services provider Mastermyne slumped from a $2.40 high to $1.44 as coal-related stocks were dumped.

However, the mining services company reported a 14 per cent lift in revenue, and a 2 per cent rise in net profit in its December half-year result. Although it lowered earnings guidance for the second half, management’s outlook for 2013-14 is “very positive”. If the well-run Mastermyne Group can grow in awful conditions, then how well will it perform when the coal sector recovers?

7. Austal

The United States-focused ship builder slumped from $2.60 in late 2010 to just 68¢ amid disappointing earnings and damage from a moribund US economy and high dollar. Austal designs, builds and maintains naval ships, commercial ferries and luxury yachts. The main game is long-term US Navy contracts.

The company’s turnaround is strengthening; a $7.3 million net profit for the December half compared with a $6.3 million loss a year earlier. Demand for Austal’s US operations is building and profit margins expanding. Its recovery could take a few years to play out, and small-cap turnaround stocks come with higher risk.

8. Select Harvests

Small agribusiness stocks caught up in the managed investment schemes fiasco in 2010 either collapsed or were punished by the market. Almond producer Select Harvests traded above $14 in 2005; last year it sunk to $1.10. Select has since raced to $2.20, thanks to rising production volumes, almond prices at a four-year high and efforts by new management and a refreshed board to lift performance and boost market confidence. Early signs of a turnaround are promising, but Select suits long-term investors comfortable with higher risk.

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